An Ill-advised "Solution" to a Serious Problem

A potentially revolutionary change in the way the Internal Revenue Service grants public charity status is in the works. Yet despite its far-reaching implications, this dramatic development has to date escaped the notice of most in the sector. 

A potentially revolutionary change in the way the Internal Revenue Service grants public charity status is in the works. Yet despite its far-reaching implications, this dramatic development has to date escaped the notice of most in the sector. 

In a Federal Register notice, the IRS recently announced its intention to allow applicants for 501(c)(3) public charity status to file a short Form 1023-EZ, a three-page document which would greatly simplify and abbreviate the process for obtaining federal tax exempt status. By checking a series of boxes, applicants attest to their eligibility for exempt status and promise not to engage in prohibited activities. And that’s about it: check the boxes, sign and send in the form, and presto, you’re a 501(c)(3), ready to accept tax-deductible contributions and foundation grants.

When I first heard about this “cross my heart and hope to die” approach I didn’t think the IRS was serious. It seemed more like a political ploy to pressure Congress for more funding to address the huge backlog of (c)(3) applications. But public comments by IRS officials seem to indicate that they really mean it.  If so, it’s an ill-advised move by the Exempt Organizations section of the IRS, battered on several fronts lately and dealing with thousands of applicants frustrated by long waiting times.

There’s no doubt the current system is broken. Many groups have been waiting an unconscionably long time – often 12-18 months - for a determination letter. So streamlining the process would be a welcome change; turning it into a pro forma, rubber stamp approval is another thing entirely. The current 25-page Form 1023 may be cumbersome but it does a pretty good job of weeding out would-be charlatans and others who don’t meet the standard for 501(c)(3) status. If public charity status is available by return mail to anyone willing to check a few boxes, it may take some pressure off the IRS in the short term but it won’t make the agency’s job easier; on the contrary, it will create a different – and potentially far worse - problem: monitoring the activities of a much larger number of organizations to assure that their activities meet the requirements of Chapter 501(c)(3), after the fact.  Putting that genie back in the bottle is likely to prove extremely difficult.

IRS officials have said they plan to reallocate resources to the review of Form 990’s and other compliance measures, focusing on what organizations are actually doing rather than what they say they’re going to do. But all that does is shift the problem from the front end to the back end of the process. With (c)(3) status so easy to obtain, the number of nonprofits requiring compliance monitoring is sure to skyrocket.

It’s hard to see how transferring staff from reviewing applications for public charity status to monitoring 990’s is good public policy.  The vast majority of 1023 submissions are legitimate and approved routinely but it’s a logical fallacy to assume that if careful up-front review is eliminated the percentage of bona fide applications will remain constant. On the contrary, making exempt status automatic virtually guarantees that many who have self-selected out of the current daunting application – including some who would not pass muster today - will take advantage of the streamlined process.  It’s as if the IRS is throwing up its hands and saying, “Well, we can’t keep up with the number of applications for tax-exempt status so we’ll just assume all these groups are legitimate and sort out the cheaters down the road.”  Right. 

With 501(c)(3) status available on demand, the door would be open for widespread abuses of the tax code.  Moreover, if this change goes into effect, it will put a much greater burden on Attorneys General and Secretary of State offices, where those agencies now rely on IRS approval as verification of the bona fides of the nonprofit organizations they oversee. And speaking of unintended consequences, it doesn’t take much of a stretch to envision chaos ensuing with respect to fundraising and foundation grantmaking if the field is suddenly flooded with hundreds of thousands if not millions of newly minted (c)(3)’s.

We may find out soon enough: the IRS plans to put the new form into effect this summer.

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